Will the ECB QE Save the Euro?

Philip Arestis and Malcolm Sawyer

The international financial crisis of 2007-2008 and the subsequent “Great Recession” have added to the problems of the euro area, which had long suffered from a poor design and inadequate policy framework. These problems have been faced in a number of ways—many, such as the Fiscal Compact which replaced the Stability and Growth Pact, distinctly unhelpful.

The European Union (EU) summit meeting, June 28-29, 2012, took a number of decisions: banking licence for the European Stability Mechanism (ESM) that would give it access to ECB funding and thus greatly increase its firepower; banking supervision by the ECB; a “growth pact,” which would involve issuing project bonds to finance infrastructure. Two long-term solutions were proposed: one, a move towards a banking union and a single euro-area bank deposit-guarantee scheme; another, the introduction of euro bonds and euro bills. Germany resisted the latter, arguing that it would only contemplate such action under a full-blown fiscal union. Not much has been implemented in any case.

Further proposed changes followed. The ECB announced in July 2012 that it would do “whatever it takes” to save the euro, as the ECB President promised; it was confirmed by the ECB President after the ECB’s first meeting in 2014 (January 9) of its rate-setting Governing Council. This was considered a turning point in the euro area sovereign debt crisis. The President reiterated that monetary policy would remain ultra loose and accommodative “for as long as necessary,” with the key ECB interest rates to be kept at its level then or even lower for an extended period of time. Deflation is a particular worry in the euro area, in view of the high levels of public and private debt and the consequences of deflation for the real value of debt.

In September 2012, the ECB unveiled the Outright Monetary Transactions (OMT) bond-buying tool. The OMT has not been tested. There were also the problems of unknown finer details of the programme. In addition, there was the condition that under OMT the ECB could buy unlimited amounts of short-maturity bonds only in the secondary market of any country that signed up to fiscal conditions; it was also conditional on a government signing up for an austerity-and-reform programme.

The European Stability Mechanism (ESM), the euro area’s permanent bailout fund, was inaugurated in October 2012 as a permanent firewall for the euro area. It was designed to safeguard and provide instant access to financial assistance programs for member states of the euro area in financial difficulty, with a maximum lending capacity of €500 billion. Since October 2012, further details have emerged: the programme that might help those countries that were regaining market access shifted into a strict condition that they should have complete market access to be allowed to apply for financial assistance. Instead of publishing OMT’s legal documentation “soon” after October 2012, the ECB shifted stance to “only publish when a country applies.”

The Bundesbank, Germany’s Central Bank, opposed OMT in that it was close to monetary financing—direct borrowing by governments from their central banks—which is banned by the Maastricht treaty, although the treaty does permit the ECB to buy public debt in the secondary markets. The Bundesbank never warmed to the OMT. The matter was referred to the German Constitutional Court, which in its turn referred the ECB OMT scheme to the European Court of Justice (ECJ), the highest legal court in the EU, on  February 7, 2014. The view of the German Constitutional Court is still that the OMT programme is not covered by the mandate of the ECB; it is, therefore, “incompatible with primary law”’ (as reported in the Financial Times, February 8, 2014) and violates the German constitution. It would deprive the German government of its fiscal sovereignty for it would force it to accept any generated losses. The court considers OMT to be “monetary financing” or “debt monetisation,” whereby the Central Bank prints money to finance sovereign debt; in this view, OMT is outlawed under European treaties. It thereby “creates an obligation of German authorities to refrain from implementing it,” according to the German Constitutional Court.

On the January 14, 2015, the ECJ released an Advocate General opinion on the legality of the ECB’s OMT. The ECJ found OMT in line with EU law, with a final ruling to be issued in the coming months. The ECB at its meeting on January 22, 2015, decided to undertake QE. The ECB would purchase €60 billion of euro area bonds and other safe financial assets every month between March 2015 and September 2016, or until the inflation rate was back to the ECB’s target. This implies total purchases worth around €1.1 trillion, equal to around 10% of the EMU’s GDP. The ECB started the QE on March 9, 2015.

Whether it would be successful is an interesting and relevant question. QE requires the ECB to buy sovereign or high-quality bonds. But EMU banks, insurance groups and pension funds need these kinds of assets to meet their capital requirements. This could imply that the ECB would have to pay a higher price to encourage institutions to sell their bonds, which would imply lower if not negative yields. In any case, the ECB QE was launched when yields were very low, thereby restricting bond supplies since bond owners would be reluctant to sell. Under such circumstances interest rates would not fall any further. So banks and other relevant institutions may not be persuaded to buy riskier assets, such as equities, to boost the economy. ECB may thus not be successful (see, also, D. Oakley, “European QE may not be live up to Draghi’s hopes,” Financial Times, March 9, 2015). This argument is strengthened by the fact that since the launch of the ECB QE, corporate debt borrowing costs have not been suppressed as in the case of sovereign debt (J. Lewin, Financial Times, “Corporate bonds laid low by QE indigestion,” April 29, 2015). As a result, credit markets have been the losers of the early ECB QE. Also, in the last week of April 2015 euro area prices of sovereign debt went into reverse (Financial Times, “Party’s over Eurozone markets hit reverse as stimulus euphoria wears off,” May 1, 2015), suggesting that the initial heavy ECB buying that sent sovereign bond prices soaring, thereby pushing yields to all time lows, went into reverse.

It would actually be better if, instead of QE, the stimulus were to be fiscal policy in terms of government services and infrastructure. This would work much better in terms of stimulating economic activity, by stimulating aggregate demand, especially since the euro area economy is in recession. This would require coordinated national fiscal policies (see, also, Draghi (2014)) instead of what is in place now, namely tight fiscal policies. Even better, coordination of fiscal and monetary policies would be more effective in stimulating economic activity (Arestis (2015)).

References

Arestis, P. (2015), “Coordination of Fiscal with Monetary and Financial Stability Policies Can Better Cure Unemployment”, Review of Keynesian Economics, 3(2), 233-247.

Draghi, M. (2014), “Unemployment in the Euro Area,” Speech at the Annual Central Bank Symposium in Jackson Hole, August 22, 2014.

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